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There are various theories which have been put forward from time to time as to why the interest is paid. The most important theories are:

(1) Productivity Theory of Interest.

(2) Abstinence or Waiting Theory of Interest.

(3) Austrian or Agio Theory of Interest.

(4) Loanable Fund Theory of Interest.

(5) Liquidity Preference Theory of Interest.

(6) Modern Theory of Interest.

Let us, now, examine these theories, one by one and see how they explain the economic cause of interest.

(1) Productivity Theory of Interest:

Turgot and other physiocrats were of the opinion that interest is the reward for the use of capital in production. Interest is paid, they say, because capital is productive. The labor assisted by capital can produce more things than what they can do without it.

Example:

For instance, a man with the help of a machine can sew more clothes than without it. It is but Just and proper therefore that a part of the pool of wealth which the capital has produced should go to the lender of the capital. Interest is, thus, a payment for the productivity of capital.

Criticism:

This theory has been severely criticized on the following grounds:

(i) This theory does explain as to why the interest is paid but it throws no light as to how the rate of interest is determined.

(ii) According to this theory, interest is paid because capital is productive. This means that pure interest should vary in proportion to the productiveness of the capital. But the fact is otherwise. Pure interest tends to be the same in money market during the same period of time.

(iii) The theory only emphasizes as to why interest is demanded but it totally neglects the supply side of the capital.

(iv) Finally, the theory fails to explain as to how interest is paid for the loan borrowed for consumption purposes.

(2) Abstinence or Waiting Theory of Interest:

This theory of interest is associated with the name of Senior. According to the theory:

“Interest is a reward for abstinence. When a person saves money from his income and lends it to somebody else, he in fact makes sacrifice. Sacrifice in the sense, that he abstains from consuming the whole of his income which he could have easily spent. As abstaining from consumption is disagreeable and painful, so the lender must be rewarded for this. Thus, according to Senior, interest is the reward for abstinence from the use of capital on the part of the lender”.

This theory is rejected on the ground that saving does not necessarily involve discomfort or sacrifice. A millionaire may save and lend a major part of his income without undergoing any hardship or suffering.

Marshall, Realizing this flaw in Senior’s definition, substituted the term waiting for abstinence. According to Marshall:

“Interest is the reward for waiting. When a man saves a part of his income, he simply postpones his present consumption to some future date. During a period when money is loaned, he himself might stand in need of money. But he cannot get it back from the borrower as the period of loan is fixed. He has to wait for the return of loan. In order to encourage the spirit of waiting amongst the lenders, some inducement is necessary and this inducement according to Marshall, is interest”.

Criticism:

(i) The theory is criticized on the ground that it lays undue emphasis on the supply side of the problem and ignores the demand side which is equally important for explaining the economic cause of rent.

(ii) It is not true that all the money saved is only due to the inducement of interest. Some persons may save money even if the rate of interest is zero.

(3) Austrian or Agio Theory of Interest:

The Austrian or Agio Theory of interest was first advanced by John Rao in 1834 and later on, it was developed by the Austrian economist, Bohm-Bowerk. According to Bohm-Bowerk:

“Interest is the premium or agio which present goods command over future goods. The reason as to why present goods are preferred over future goods are as follows:

Firstly, Future is shrouded in mystery and so is uncertain. Secondly, present wants are more urgently felt than the future ones. Thirdly, present goods posses a technical superiority over future goods. Keeping in view all the conditions stated above, an individual prefers present satisfaction to a future satisfaction”.

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